What You Need to Know About the Yuan's Devaluation

A Look at China's Surprise Devaluation in Mid-August 2015

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China’s surprise 2% devaluation of the yuan shocked the global financial markets in mid-August 2015, but the central bank’s decision to subsequently defend its value suggests that the leadership remains conflicted on the currency’s value.

In this article, we will take a closer look at why the People's Bank of China opted to devalue the yuan and the effects on the global capital markets.

Why Devalue the Yuan?

The decision to devalue the yuan comes amid a slowdown across China’s economy and trouble brewing within its equity markets.

Many analysts believed that the move was designed to boost exports by making its goods and services cheaper abroad, while demonstrating that the yuan is worthy of becoming a global reserve currency. The timing of the move seemed fortuitous given the win-win of satisfying the International Monetary Fund and helping its exporters.

The IMF has been eager for the country to implement a more market-based approach to valuing its currency in order to qualify to become a global reserve currency. There’s little doubt that the devaluation has helped the cause by demonstrating that the leadership is willing to let the currency’s valuation float lower – perhaps closer to its true market valuation – rather than tightly controlling it through open market transactions and other means.

But on the other hand, the move came just days after the country’s economic data showed a large fall in exports despite interest rate cuts and fiscal stimulus measures.

Some analysts believe that the move was simply the next in a series of steps designed to stimulate the economy and perhaps a move of desperation. While the lower yuan will certainly help exports, experts remain divided on just how big and sustainable the boost will be in the end.

Taking it Too Far

Some experts saw the devaluation as potentially provoking a currency war.

In Japan, Prime Minister Shinzo Abe’s advisor suggested that the country could offset the yuan devaluation by instituting more monetary easing, while some analysts are concerned that other countries could follow suit in reducing the value of their currencies to remain competitive. Critics of this sentiment say that China’s exports have shown signs of stabilizing that negated the need.

The Chinese Central Bank also seems to be a bit concerned over the steep fall in the yuan’s valuation. Bloomberg News reported that the central bank has intervened in the market to prop up the currency’s valuation, while PBoC economist Ma Jun said that China could stabilize the currency through direct market interventions in order to avoid “the herd mentality resulting in irrational movements of the rate” – referencing the market’s forces.

International investors, the IMF, and many other parties will be closely watching the country to see just how low the yuan will be permitted to go, as well as whether or not the measure will be accompanied by other market reforms needed before the currency will become a global reserve currency – at least in the eyes of the IMF and its “Special Drawing Rights” decision that’s due for a final decision by the end of the year.

Key Takeaway Points

  • China’s decision to devalue the yuan created a win-win situation for the country by satisfying some of the IMF’s demands and simultaneously helping improve the country’s exports by making them more price-competitive internationally.
  • The sudden devaluation of the currency led to some concerns of a currency war, particularly with Japan’s export-sensitive economy, although some analysts are skeptical whether or not an escalation in devaluations will materialize.
  • China’s own central bank appears to be somewhat concerned over the steep fall in valuation with reports that it has spent capital defending the currency’s valuation via direct interventions in the foreign exchange market.